How To Build Credit
When you’re preparing for a financial milestone, such as buying a house or applying for a loan, there’s one key factor to keep in mind: credit. Your credit serves as a representation of your finances – both past and present – for banks and lenders.
Depending on your history, your credit can be either your biggest ally or your hardest obstacle. Poor credit can make it difficult to achieve your financial goals, while good credit can speed up the process and lead to more favorable loan terms. But for those with no credit at all, the most difficult question may be where to start. In this article, we’ll explain how credit works, why it’s important and the simplest ways to begin building credit.
What Is Credit?
When it comes to credit, there are two specific sides to consider: credit reports and credit scores. Each individual has three credit reports maintained by different national credit bureaus – ExperianTM, Equifax® and TransUnion®. These reports keep track of your open credit card and loan accounts and show record of your payment history, including any late or missed payments, as well as any recent financial mistakes, including bankruptcies, foreclosures or accounts that have fallen into collections.
Using the information from your credit report, each of these credit bureaus determines a person’s three-digit credit score – and because the information reported to each bureau may vary, each person actually has three different credit scores. In general, credit reports filled with late payments, high credit card debt and other financial mishaps ultimately lead to low scores.
Your credit score and history matter for many reasons – most notably because they are used to signify your financial stability and responsibility in situations where you need to build trust, such as when you’re renting an apartment, getting a car or buying a house. The score that carries the most weight is the FICO® Score, determined using a scoring model by the Fair Isaac Corporation, which is used by most lenders when determining whether you qualify for a loan.
What Is Good Credit?
FICO® Scores range from a low of 300 to a high of 850. Good credit shows you as being in good financial standing and therefore the higher your score, the easier time you will have finding lenders and credit card companies to work with. In general, a credit score is considered good when it is 620 or higher, with scores of 740 or higher considered excellent.
The exact formula used to calculate credit scores is protected by FICO®, but the five major factors that impact your score include the length of your credit history, your payment history, credit utilization, recent credit inquiries and the overall credit mix – aka the types of credit you have, such as revolving accounts like credit cards and installment loans like a mortgage, student or personal loan.
What Credit Score Is Needed For A Mortgage?
You need a good credit score to buy a house, but the exact score needed depends on the mortgage loan type and lender. Typically, the minimum score required is between 580 and 620 for Rocket Mortgage®. There are other factors considered for loan approval, such as the debt-to-income (DTI) ratio, but higher credit scores can secure better interest rates and lead to a higher likelihood of approval.
How Long Does It Take To Build Credit?
Having a poor credit score can make it challenging to reach your financial goals, but the same can be said for those with no credit at all. If your credit score is nonexistent, it’s important to begin building credit months to years in advance of applying for a loan or mortgage, as it takes time for all three credit bureaus to build your report. In general, you can expect to see a score after about 6 months of building credit, although it may take longer for this to be reported to each credit bureau.
How Can I Build Credit?
So how do you build credit from scratch? The good news is you have a few options. Everything from secured credit cards to short-term credit-builder loans can be a good place to start and help your credit file grow over time.
Does Paying A Mortgage Build Credit?
As with any major lines of credit, a mortgage will appear on your credit report, which inherently means any payments you make on a mortgage will improve your credit overtime. However, in the short term the mortgage may actually cause your credit score to decrease by a few points. This is due to the hard credit inquiry required for mortgage lenders to approve the loan. It will also be difficult – if not impossible – to find a mortgage lender that will approve your loan without an established credit history to rely on.
How To Build Credit With A Credit Card
The most popular option to begin building credit is through a credit card. Whether it’s a secured or unsecured card, properly utilizing a credit card can be a great way to establish payment history and demonstrate your ability to manage your finances.
Apply For Your First Credit Card
When banks and financial institutions give consumers credit cards, they are taking a certain level of risk that the card owner could be unwilling or unable to repay their debt. This risk is higher when consumers don’t have established credit history, which means it most likely will be difficult for those without credit to be approved for unsecured credit cards – meaning traditional cards where the debt is not backed by collateral.
This is where secured credit cards step in. A secured card functions similarly to traditional cards but requires the user to make a cash deposit at the time of card opening. This cash deposit is directly equivalent to the credit limit. For example, let’s say you deposit $500 when taking out a secured credit card. The bank or financial institution holds onto that money and your credit limit is now $500, which you can slowly use and make payments on. This minimizes your bank’s risk, because if you stop paying your credit card bill, they will take what you owe out of your initial deposit. This security is what makes it easier for people with little to now credit to get approved.
Although secured cards may seem limiting, they’re a great way to begin building credit as they allow you to make monthly payments, which will steadily boost your credit score over time. When possible, paying the card balance in full each month is ideal. If you can’t pay them off in full every month, be sure to at least make the minimum payment on time, as missed or late payments will cause your credit score to decline. Therefore, making sure your card is used properly and no mistakes are being made is crucial.
Become An Authorized User On Someone Else’s Credit Card
If you’re having trouble qualifying for your own credit card, becoming an authorized user on someone else’s may be a better option. This happens when someone you know – typically a family member – adds your name to their existing account. This gives you the ability to make purchases on the card without being responsible for the payments.
But this is only a good idea if you can confidently trust the cardholder to make their payments on time. Why? When the main user of the card pays their bill each month, this payment will also be reflected on your credit report, ultimately boosting your score. On the flip side, this means if the cardholder misses payments or makes them late, it could end up hurting your credit rather than helping it.
Don’t Miss Any Payments
Lenders want to know you’re capable of making timely payments, so the importance of not missing payments cannot be understated when building credit. Missing payments will negatively impact your score, so when making purchases with a credit card, you should always know exactly when and how you will be able to make your next payment.
How To Build Credit Without A Credit Card
If you’re looking to build credit without the use of a credit card, you have other loan options to consider.
Take Out A Loan
Taking out a loan can help you build credit similarly to a credit card, as your regular monthly payments demonstrate your ability and commitment to repay your debt. There are several types of loans you can consider depending on your situation, but one of the best options is a credit-builder loan – a loan offered by certain smaller banks and credit unions that is specifically designed for people with little to no credit. These loans require a small deposit upfront, which is then paid back each month. The payments are reported to the credit bureaus, building credit very similarly to a secured credit card.
Although credit-builder loans are a good option, it’s important to note that many financial institutions don’t offer this option, so you may have to do some research to find a loan provider. Personal loans will be easier to find but may be harder to qualify for. If you’re pursuing higher education, taking out and paying off student loans may be an easier approach to building credit.
Monitor Your Credit Report
Information is power, so regardless of which path you choose, it’s important to consistently monitor your credit report while building credit. Knowing where you stand can help you plan your next financial milestone, so be sure to check your account regularly. If you see any inconsistencies in your credit report, inquire about them immediately, as fixing a small mistake could quickly boost your score. When in doubt, you can also consult a financial advisor for additional ways to improve your credit score.
The Bottom Line
A high credit score can be an endlessly powerful tool in your pocket. When it comes to financial milestones, very few of us can take on the full weight on our own. Banks, lenders and other financial institutions can be a helpful and often necessary ally when it comes to making large purchases such as buying your first home, and the higher your credit score, the more likely they’ll want to work with you. But if your credit is poor or nonexistent – don’t fret! There are options to help you find the path to financial success.
Ready to take the next step? Learn more about the credit requirements you’ll need for the type of mortgage loan you will use to purchase your first home!